2. Hedging is a financial strategy that should be understood
and used by investors because of the advantages it offers.
As an investment, it protects an individual’s finances from
being exposed to a risky situation that may lead to loss of
value. However, hedging doesn’t necessarily mean that the
investments won’t lose value at all. Rather, in the event that
happens, the losses will be mitigated by gains in another
investment.
Hedging is recognizing the dangers that come with every
investment and choosing to be protected from any untoward
event that can impact one’s finances. One clear example of
this is getting car insurance. In the event of a car accident,
the insurance policy will shoulder at least part of the repair
costs.
3. Hedging is the balance that supports any type
of investment. A common form of hedging is a
derivative or a contract whose value is
measured by an underlying asset. Say, for
instance, an investor buys stocks of a company
hoping that the price for such stocks will rise.
However, on the contrary, the price plummets
and leaves the investor with a loss.
4. Such incidents can be mitigated if the investor
uses an option to ensure that the impact of such
a negative event will be balanced off. An option
is an agreement that lets the investor buy or sell
a stock at an agreed price within a specific
period of time. In this case, a put option would
enable the investor to make a profit from the
stock’s decline in price. That profit would offset
at least part of his loss from buying the stock.
This is considered one of the most effective
hedging strategies.
5. There are various hedging strategies, and
each one is unique. Investors are
encouraged to use not just one strategy,
but different ones for the best results.
Below are some of the most common
hedging strategies that investors should
consider.
6. 1. Diversification
The adage that goes “don’t put all your eggs in one
basket” never gets old, and it actually makes sense even
in finance. Diversification is when an investor puts his
finances into investments that don’t move in a uniform
direction. Simply put,
it is investing in a variety of assets that are not related to
each other so that if one of these declines, the others
may rise.
For example, a businessman buys stocks from a hotel, a
private hospital, and a chain of malls. If the tourism
industry where the hotel operates is impacted by a
negative event, the other investments won’t be affected
because they are not related.
7. 2. Arbitrage
The arbitrage strategy is very simple yet very clever. It
involves buying a product and selling it immediately in
another market for a higher price; thus, making small
but steady profits. The strategy is most commonly used
in the stock market.
Let’s take a very simple example of a junior high school
student buying a pair of Asics shoes from the outlet
store that is near his home for only $ 45 and selling it to
his schoolmate for 70. The schoolmate is happy to find
a much cheaper price compared to the department store
which sells it for $ 110.
8. 3. Average down
The average down strategy involves buying more units
of a particular product even though the cost or selling
price of the product has declined. Stock investors often
use this strategy of hedging their investments. If the
price of a stock they’ve previously purchased declines
significantly, they buy more shares at the lower price.
Then, if the price rises to point between their two buy
prices, the profits from the second buy may offset
losses in the first.
9. 4. Staying in cash
This strategy is as simple as it sounds.
The investor keeps part of his money in
cash, hedging against potential losses in
his investments.
10. Hedging can be used in various areas such as
commodities, which include things such as gas, oil,
meat products, dairy, sugar, and others.
Another area is securities, which are most commonly
found in the form of stocks and bonds. Investors can
buy securities without taking possession of anything
physical, making them an easily tradable property.
Currencies can also be hedged, as well as interest rates
and weather.
11. Conclusion
Hedging is an important protection that investors can
use to protect their investments from sudden and
unforeseen changes in financial markets.
